THE OPEN ECONOMY

Wahyu Alfa Omega

150810101005
Misbahol Yaqin
150810101110
Desita Natalia Gunawan
150810101209

slide 2

The International Flows of

Capitald and
Goods
f
superscripts:
C C

d =spending on
I I I
domestic
d
f
goods
G G G
f = spending on
foreign goods
EX = exports =
foreign spending on domestic goods
IM = imports = C f + I f + G f
= spending on foreign goods
d

NX = net exports (a.k.a. the trade balance)

= EX IM

GDP = expenditure on
domestically produced g & s
slide 3

Y Cd I

G d EX

(C C ff) (I I ) (G G f ) EX
C I G EX (C ff I
C I G EX I M
C I G NX

Gf )

The national income identity

in an open economy
slide 4

Y = C + I + G + NX
or,

NX = Y (C + I + G )

net
exports

domestic
spending
output

Trade surpluses and deficits

slide 5

NX = EX IM = Y (C + I + G )

trade surplus:
output > spending and exports > imports
Size of the trade surplus = NX

trade deficit:
spending > output and imports > exports
Size of the trade deficit = NX

International capital flows

slide 6

Net capital outflows

= S I
= net outflow of loanable funds
= net purchases of foreign assets
the countrys purchases of foreign assets
minus foreign purchases of domestic
assets

When S > I, country is a net lender

When S < I, country is a net borrower

slide 7

NX = Y (C + I + G )
implies
NX
= (Y C G ) I
=
S
I
trade balance = net capital outflows

Thus,
Thus,
aa country
country with
with aa trade
trade deficit
deficit ((NX
NX <
<
00))
is
is aa net
net borrower
borrower ((SS <
< II ).).

slide 8

Saving and Investment

in a Small Open Economy

An open-economy version of the

loanable funds model.
Includes many of the same elements:
production function: Y Y F (K , L)
consumption function:
investment function:

C C (Y T )
I I (r )

exogenous policy variables: G G , T T

Assumptions re: capital flows

slide 9

a. domestic & foreign bonds are perfect

substitutes (same risk, maturity, etc.)

b. perfect capital mobility:

no restrictions on international trade in assets

c. economy is small:

cannot affect the world interest rate, denoted r*

aa &
& bb imply
imply rr =
= r*
r*
cc implies
implies r*
r* is
is exogenous
exogenous

But in a small open economy

slide
10

the
exogenous
world interest
rate
determines
and the
investment
difference
between
saving and
investment
determines
net capital
outflows and
net exports

S
NX

r*
rc
I (r )
I1

S, I

slide 11

How Policies Influence the

Trade Balance
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment

demand

1. Fiscal policy at home

r

slide 12

An increase in
G or decrease
in T reduces
saving.

*
1

S 2 S1
NX2

NX1

Results:

I 0
I (r )

NX S 0
I1

S, I

2. Fiscal policy abroad

r

slide 13

Expansionar
y fiscal
policy
abroad
raises the
world
interest rate.
Results:

NX2

r2*

S1

NX

*
1

I 0

I (r )

NX I 0
*
2

I (r )

I (r1* )

S, I

slide 14

3. An increase in investment
demand
r

An Increase in
investment demand
leads to a trade deficit

NX

I (r )2
I (r )1
I,S

Exchange Rate
slide 15

e =

nominal exchange
rate,
the relative price of
domestic currency
in terms of foreign currency
(e.g. Yen per Dollar)

slide 16

=
the
lowercase
Greek letter
epsilon

real exchange rate,

the relative price of
domestic goods
in terms of foreign goods

Understanding the units of

slide 17

e P
P*

(Yen per $) ($ per unit U.S. goods)

Yen per unit J apanese goods

Yen per unit U.S. goods

Yen per unit J apanese goods

Units of J apanese goods

per unit of U.S. goods

 in the real world & our model

slide 18

In the real world:

We can think of as the relative price of
a basket of domestic goods in terms of a
basket of foreign goods

In our macro model:

Theres just one good, output.
So is the relative price of one
countrys output in terms of the other
countrys output

The net exports function

slide 19

The net exports function reflects

this inverse relationship between NX
and :

NX = NX ( )

How is determined
slide 20

The accounting identity says NX = S I

We saw earlier how S I is determined:
S depends on domestic factors (output,
fiscal policy variables, etc)
I is determined by the world interest
rate r *
So, must adjust to ensure

NX( ) S I r( * )

Interpretation: supply and demand in

the foreign exchange market
slide 21

demand:
Foreigners need
dollars to buy
U.S. net exports.

supply:
The net capital
outflow (S I )
is the supply
of dollars to be
invested
abroad.

S1 I (r *)

NX 1

NX(
)
NX

Four experiments
slide 22

1. Fiscal policy at home

2. Fiscal policy abroad
3. An increase in investment

demand
4. Trade policy to restrict imports

1. Fiscal policy at home

A fiscal expansion
reduces national
saving, net capital
outflows, and the
supply of dollars in
the foreign
exchange
market

slide 23

causing the
real exchange
rate to rise
and NX to
fall.

S 2 I (r *)

S1 I (r *)

2
1

NX 2

NX 1

NX(
)
NX

2. Fiscal policy abroad

slide 24

An increase in r*
reduces investment,
increasing net
capital outflows and
the supply of dollars
in the foreign
exchange market

causing the
real exchange
rate to fall
and NX to
rise.

S1 I (r1*)

S1 I (r2* )

1
2

NX 1

NX 2

NX(
)
NX

3. An increase in investment

demand
slide 25

An increase in
investment
reduces net
capital outflows
and the supply
of dollars in the
foreign
exchange
market

causing the
real exchange
rate to rise
and NX to
fall.

S1 I 2

S1 I 1

2
1

NX 2

NX 1

NX(
)
NX

4. Trade policy to restrict imports

slide 26

At any given value

of , an import
quota
IM NX
demand for
dollars shifts
right

Trade policy
doesnt affect S or
I , so capital flows
and the supply of
dollars remains
fixed.

S I

2
1
NX ( )2
NX ( )1
NX1

NX

4. Trade policy to restrict imports

slide 27

Results:
> 0
(demand
increase)
NX = 0
(supply
fixed)
IM < 0
(policy)
EX < 0
(rise in )

S I

2
1
NX ( )2
NX ( )1
NX1

NX

The Determinants of the

Nominal Exchange Rate
slide 28

Start with the expression for the real

exchange rate:

e P
*
P

Solve it for the nominal exchange rate:

P*

Purchasing Power Parity (PPP)

slide 29

Two definitions:

a doctrine that states that goods must sell at

the same (currency-adjusted) price in all
countries.
the nominal exchange rate adjusts to
equalize the cost of a basket of goods across
countries.

Reasoning:

arbitrage, the law of one price

Purchasing Power Parity (PPP)

slide 30

e P = P*

Cost of a basket
of foreign
goods, in foreign
currency.
Cost of a basket
Cost of a basket
of domestic
of domestic
goods, in foreign
goods, in
currency.
domestic
Solve for e : currency.
e = P*/ P

PPP:

PPP implies that the nominal exchange

rate between two countries equals the
ratio of the countries price levels.

Purchasing Power Parity (PPP)

slide 31

If e = P*/P,
then

P
P* P
e *
* 1
P
P
P

and the NX curve is

horizontal:

S I

=1

NX

NX

Under PPP,
changes in (S
I ) have no
impact on or e.

Does PPP hold in the real world?

slide 32

No, for two reasons:

1.International arbitrage not possible.

nontraded goods
transportation costs

2.Goods of different countries not perfect

substitutes.
Nonetheless, PPP is a useful theory:
Its simple & intuitive
In the real world, nominal exchange
rates have a tendency toward their PPP
values over the long run.

A fiscal expansion in three models

A fiscal expansion causes national saving to fall.
The effects of this depend on the degree of
openness:
closed
large open
small open
econom
economy
economy
y
rises, but not as
no
rises
much
r
change
as in closed economy
falls, but not as much
no
falls
I
change
as in closed economy
falls, but not as much
no
falls
as in small open
NX change
economy
slide 33

Chapter summary
slide 34

1. Net exports--the difference between

exports and imports

a countrys output (Y )

and its spending (C + I + G)

2. Net capital outflow equals
purchases of foreign assets
minus foreign purchases of the countrys
assets
the difference between saving and investment
3. National income accounts identities:
Y = C + I + G + NX
trade balance NX = S I net capital outflow